Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 160-179)


24 OCTOBER 2006

  Q160  Ms Keeble: Do you think the balance is right at the moment, or not?

  Sir Callum McCarthy: No, I think the balance is clearly wrong because there is a huge information asymmetry between the strengthened power of the producers and the ability of many consumers, and that is something that we are trying to tackle in all sorts of ways.

  Q161  Chairman: Sir Callum, on the issue of Northern Ireland, I was over there in the summer talking to many people on the issue of financial inclusion, which the Committee is interested in. The Consumer Council and others brought to my attention the fact that there is no office of the FSA in Northern Ireland and, furthermore, there is a lack of targeted resources and activities relating to specific financial issues for consumers in Northern Ireland. It is that area that they were focusing on. I think there is something the FSA could do to raise its profile there.

  Sir Callum McCarthy: Could I take that away, Chairman? We will look into it.[3]

  Q162 Mr Breed: Can we just turn briefly to an area of activity which causes me and, I think, some others concern, and that is hedge funds. Can I just draw your attention to Mr Tiner's report in the annual report, which says: "We have been careful to be proportionate in our regulation of hedge fund managers bearing in mind the highly mobile nature of their business and their ability to trade into the UK from overseas." Then turning to your memorandum that you sent to us, it says, amongst other things: "FSA authorised firms account for over three-quarters of the hedge fund assets managed by European based firms." The first question is: do you think that you have got the balance right if the regulation is such that it attracts three-quarters of the hedge funds, and are you happy that the existing regulatory regime is sufficient? Second: in the last part of your report in this respect you say: "We have set up a specialist hedge fund unit to carry forward our regulation of these firms". Can you perhaps give us some indication as to what that unit is doing and how you believe that regulation may be, perhaps, improved without disproportionately affecting the competitive nature of the UK?

  Sir Callum McCarthy: Can I just say that we approach hedge funds on the same risk-based approach that we approach all our activities. There are a very large number of hedge fund managers in London, most of whom come and go because, like all hedge fund managers, their half-life is relatively short. The challenge for us is, first of all, we authorise all hedge fund managers to make sure that we have got a proper authorisation process, and then the question is: how do we actually exert our influence most productively. We have chosen to do it in two ways: one is we have a six-monthly survey of the prime broker dealers, which are the institutions which extend most of the credit and other facilities to the hedge fund managers, and that gives us a means of looking at the total exposure of hedge funds, which is important in terms of the prudential issues which are raised—i.e. the threat to financial stability. That we have done. We publish the results of that and discuss the results of that with the prime broker dealers, and we can talk about that. The other thing that we have done is to identify some 35 hedge fund managers who are responsible for sufficiently large chunks of activity for us to really supervise them in a way that is comparable to the way that we supervise other high impact firms. For those we discuss with them carefully their systems and controls and a whole range of other issues. Those are the essential features that we have done, and I think it fair to say that other regulators around the world are watching what we are doing with great interest because the regulation of hedge fund managers raises an interesting and quite difficult set of issues.

  Mr Tiner: I think the success of London, if that is the right way to describe it, has not been because there is a weak regulatory system here. I think if you look at other international capital markets, the international credit markets, the international bond markets—certainly the international corn exchange markets—the sort of percentages that you quoted for hedge funds would apply there as well in the European context, with London being either number one or number two to New York in many of these markets. I think it just follows a pattern. Our worry would be that if we had a disproportionate effect on these companies that they would take their business offshore but they would still trade the markets in London, and so we would, in a way, lose touch and then lose the ability to actually intervene. I think that the regime we now have, which Callum has described, and the specialist team we have recruited are now looking quite critically at things like how the hedge funds are managing their conflicts of interest, because it is quite often that the hedge funds are taken in over the wall, so to speak, and when an investment bank is trying to put together a transaction or a convertible bond is being converted into equity, or whatever, the market is being tested. We are very keen to see at close hand how the hedge funds are handling that kind of risk so that they do not trade on that sort of inside information, for example. That specialist team is quite active particularly following the major 35 hedge funds which comprise a large part of the market. I think there is one thing which is slightly curious: whenever I go and meet the hedge fund managers as a group they all seem to be terribly keen to be regulated by us. I say to them: "I think you are a bit too keen", because I think there is some sense that we are a badge of respectability and we just have to be wary of that as well, I think.

  Q163  Mr Breed: Is the unit going to be publishing any findings? Has it unearthed any concerns?

  Mr Tiner: The unit will produce public reports when they do what we call thematic work; so when they look at particular themes. For example, they look at how hedge funds value their illiquid and complex positions; they look at conflicts of interest, and at the moment they are looking at side letters with major investors that we, in fact, talked about earlier this year. Yes, the results of that will be made public in a general sense.

  Q164  Kerry McCarthy: With the move towards more of a principles-based regulation away from rules, what efforts have you made to ensure that the consumer does not lose out? You will be aware, I am sure, of criticism from Which? that you have not conducted any sort of cost-benefit analysis of the impact on the consumer. Do you think that is something that you should have done or should be doing?

  Mr Tiner: I suspect it is not possible to do, is the truth of it, because you would have to make so many assumptions about actually how many more principles would be working in practice to determine whether the consumer is better off or not. It is our very strong belief that the highly prescriptive nature of the current regulations has meant that the companies have focused much more on the ticking of boxes than thinking about what do they actually need to do to treat their customers fairly. We are trying to turn the whole focus of the financial services industry to building Treating Customers Fairly, in all its component parts, into their business processes, and the way in which they motivate people, the way in which they reward people and, indeed, to try and see (and many companies are coming forward with very good ideas about this) how they can create shareholder value out of treating their customers fairly. So the regulation does not become something which they have to do in a very rigid way, which the research might suggest the consumer does not understand well enough, to one where the consumer is much more at the heart of their business. So that is somewhat an act of faith, I would accept.

  Q165  Kerry McCarthy: Is not the problem that the vast majority of firms will be quite willing to go down the route but then you lose the power to more strictly control, maybe, the 5% or so that are not willing?

  Sir Callum McCarthy: I think there is a danger in believing that our movement towards more principles-based regulation is, as it were, driven by a desire to impose lower costs on the producers and the firms. That is not the principal driving force. It may be—and I think will be—a good side benefit, but this is driven by a belief that this is a better way of actually achieving our statutory objectives, including that central statutory objective of appropriate consumer protection. I do not believe there is a tension between appropriate consumer protection and a more principles-based regulation.

  Q166  Kerry McCarthy: As you move towards a principles-based approach there will be a need for guidance, presumably. How do you strike that balance so that the guidance does not, in effect, become another set of rules?

  Mr Tiner: A very good question indeed. If you think about the paper that we have just published that Callum referred to a moment ago on distributor and product provider responsibilities, they are setting out our thinking about that aspect of treating customers fairly. We do not intend to turn that into formal guidance, which then has the degree of formality you are describing and becomes a sort of second set of rules. However, it is important the industry should know what is in our minds, and the industry can then work out how to interpret it. There is also a fear then, beyond that, about how can we take enforcement action where we do not have a precise rule to point to but we have a breach of a principle? We are quite satisfied that that will not curtail our enforcement activity. In fact, many of our enforcement cases, which is not a well known fact, have been based on principles already. I think the legal ground is well developed there.

  Sir Callum McCarthy: Of the fines, which were among the largest fines that the FSA has ever imposed, at least two of them have been for breaches of principles: the Citigroup MTS trade fine was for a breach of a principle, and the recent Deutsche case was for a breach of principle. So I do not think that the movement towards more principles-based regulation is going to inhibit us or prevent us from actually taking enforcement action against, as you said, the 5%.

  Q167  Kerry McCarthy: You think that firms can cope—particularly the smaller firms. Is there not a danger that they are going to adhere to the guidance just because they do not want that degree of uncertainty? You talk about them taking the guidance as guidance and making their own decisions as to how they operate, but there must be some firms that will think: "We do not want to run the risk of being deemed to be outside the principles".

  Mr Tiner: I have heard it said that this is fine for large firms with very large legal departments, compliance departments and risk management departments, and very difficult for the sole trader. Actually, I am not sure about that. I think it may almost be the opposite. I think in the large companies these legal departments and compliance departments are saying to their senior management: "We like this very prescriptive approach because we can (a) do the job and (b) we know where we are on everything", which, frankly, I think reduces the sense of management responsibility at the top for doing the right thing. I think the small trader can look at it and say: "I can look at myself in the mirror and say: am I treating my customers fairly in this respect?" There is plenty of help around on that, on our website and other places, to help them to come to terms with it. I do not think they will need large departments and access to lots of consultants to do that.

  Q168  Kerry McCarthy: Final question: in terms of the staff that you employ, has this caused an issue in that you are used to regulators that are there to apply rules and they are now to interpret principles and issue guidance? Have you had to make new appointments or re-jig things around?

  Sir Callum McCarthy: The move that we are determined to make raises really big issues both for firms and for us as a regulatory organisation. We have, for example, recently had a major training exercise to train large numbers of people in terms of the new way that we do a central risk assessment called ARROW. We have a whole series of other changes that will be required as we roll this out over the years to come. It is a big cultural and managerial change in the FSA.

  Q169  Mr Gauke: I would like to turn to the issue of MiFID. Last year Kerry asked you, Sir Callum, about whether the costs would outweigh the benefits. Your response was to the effect that it was really too early to say at that point. We are a year further on, and I know the process is not complete, but where do you think we stand at the moment?

  Sir Callum McCarthy: I think the first thing I would say, Chairman, is that it is still a bit too early to tell—it is a bit like Mao Tse Tung and the French Revolution.

  Mr Cousins: I think it was Zhou En Lai.

  Sir Callum McCarthy: I am sure it would have been Mao Tse Tung as well! It just shows you should never go beyond your remit! If I can return more seriously to the question, we are required to do a cost-benefit analysis of all the rule changes that arise out of MiFID, and have done so. In addition, even though we are not required to do so, we have made an estimate of the total cost in the UK of implementing MiFID. We think that it will be between three-quarters and one billion sterling, and that is based on what we now know. We think that the implementation cost will be in that range. We will publish our work on that next month. The benefits are much more difficult to estimate but we think that they are likely to include continuing benefits of around £200 million a year and then there are wider benefits which could be very significant and which are, at the moment, almost totally unknown. If the cost of capital, either equity or debt, in Europe were to come down by one or two basis points that would have a quite fundamental effect, and we will just have to wait to see whether that actually happens—if, after the event, it is possible to untangle it. I would just make one other point: as I said at the annual public meeting of the FSA last year, one of the things which I regard as deeply regrettable is that there has been this huge initiative, important and costly initiative, which was done without proper cost-benefit analysis within the Commission. We very strongly support Commissioner McCreevy in his determination to use impact assessment and cost benefit analysis, because it is not a good thing that at this very late stage we should not be able to answer the question you have raised.

  Q170  Mr Gauke: Would it be fair to say that it is easier to quantify the costs at this stage than it is to quantify the benefits?

  Sir Callum McCarthy: Yes.

  Q171  Mr Gauke: Looking at the costs, can I ask to what extent you think the costs are going to be incurred because of the terms of the original Directive, if you like, and to what extent the costs are going to result as a consequence of implementation by the FSA? Perhaps, in answering that question, you could answer the concern that as a whole the FSA have, perhaps, been overly literal, or overly cautious in its implementation. I know best execution is one that is often mentioned, but how do you respond to those concerns?

  Sir Callum McCarthy: Can I take the issue of gold-plating generally? Our general policy has been copy out, which is the most basic transmission that is possible. There are a very limited number of instances where we have thought it right to go beyond the Directive. Each of those will be justified by both an analysis of market failure and a cost-benefit analysis. For example, there are some reporting issues where we think there is a good case in terms of our ability to oppose market abuse. There are also one or two instances where we have existing requirements which we are, pro tem at least, going to maintain because we think they are useful (there are issues associated with the menu and IDD which fall into that category). Generally, we are taking a very cautious copy out approach.

  Mr Tiner: May I add two points in addition to the points Callum has made about where we would go beyond. One is what we have done on soft commissions and the unbundling of research, which has been very widely welcomed—and strangely, in my mind, does not fit into MiFID. We have to make the case to keep that, but it is something that has worked very well for London in the two years since that market has been unbundled. The other area where I think there is quite a bit of misunderstanding and misconception, is that we have gone beyond on best execution, where we are publishing a paper about our proposals on best execution either later on this week or on Monday. It is clear to me that we are not and that the great advantages to London over many years of the dealer market, the principal-to-principal market, the very deep liquidity pools that exist in some markets, we can keep within the terms of the directive. The directive does raise significantly the expectations by institutional investors, fund managers, that if they ask for best execution they shall be given it. That is not a function of regulation; it is a function of the raising of the issue through the MiFID. But I am quite satisfied, as I said in my speech at the British Bankers' Association two weeks ago, that we do now have a solution to best execution, which has not been easy to arrive at—because it is written in very complex ways and all over the place within MiFID and to make sense of it in a real market sense has not been easy—but I think we have ended up in a good place.

  Q172  Mr Gauke: You feel that the industry will be satisfied with the full details?

  Mr Tiner: All the soundings I have taken suggest that will be the case, yes.

  Q173  Mr Gauke: The logic of what you are saying—and best execution provides a good illustration—is that there are a lot of problems in the original MiFID text, if you like. Do you think it was wise for the Treasury to agree to the MiFID text as it currently stands? Did the Treasury have the grasp of the detailed issues and the industry contacts that the FSA clearly has when it was negotiating at a level 1 stage?

  Sir Callum McCarthy: I think the answer, basically, to that is yes. They had that knowledge, partly because we helped them, in addition to their own contacts. Truthfully, the questions there must be on any negotiation of a directive are a whole series of tactical questions, on which I cannot comment at all because that depends on people who are immersed in the negotiation. In terms of, did they have access to an understanding of what the implications were: yes, and we helped give them that understanding and they then took the decisions.

  Q174  Mr Gauke: From the FSA's point of view, given the very substantial costs that are going to be there—some uncertain benefits but substantial costs—do you feel there were too many compromises made? Was it a compromise that was in the UK's best interest?

  Sir Callum McCarthy: I do not think that I am competent to make that judgment because it depends on a whole variety of other issues which are, in that great phrase, "above my pay level".

  Mr Gauke: Mr Tiner, do you have anything to add?

  Q175  Chairman: If it is above Sir Callum's, it is above yours, is it not?

  Mr Tiner: Thank you, Chairman, for getting me out of that one!

  Q176  Chairman: David mentioned market abuse and one area of market abuse that has been brought to our attention is insider trading. I know that your own statistics show a marked tendency for abnormal price movements to occur ahead of key corporate announcements. This is an area, as a Committee, we are thinking of looking at, but the ABI have written to us as well saying that they believe there are far too many anticipatory share-price movements ahead of price-sensitive announcements. What are you doing about that?

  Sir Callum McCarthy: First of all, we are trying to raise the awareness of this. That is why we published the research to which you have referred, Chairman. We are also investing very heavily in a new IT system which will enable us to look at the market and across the market and identify aberrations better. We are also, as John mentioned in relation to, for example, hedge fund managers, making sure that we pursue the importance of segregation of information and pursue those instances when there appears to be breaches of it. I would say that we have had at least one successful prosecution, which was the GLG and Mr Jabre enforcement action, where we took action against both a firm and an individual for the way in which they used information improperly.

  Q177  Mr Love: Following up on that, could we say that Gordon Gekko has moved from the United States to the UK because of easier dealings in the London market?

  Sir Callum McCarthy: I would basically say that there is no evidence for that at all! I am sorry, that was a slightly flip answer. I do believe that the question of market abuse and insider dealing is a real question. It is a question which in the UK and elsewhere it has been extraordinarily difficult to deal with and we are determined to deal with it in as focused a way as we can.

  Q178  Mr Love: Do you think you are dealing with it as effectively as the United States?

  Sir Callum McCarthy: If you look at the evidence in terms of what has been described as anticipatory market movements, I do not think there is any evidence that the US is a cleaner or fairer market than the UK.

  Q179  Mr Love: In the year 2005 the FSA produced a report on offshore operations. In the light of the Dispatches report that appeared on television a couple of weeks ago—and I hope both of you are aware of that—about data protection in Indian call centres, do you have any plans to revisit this particular report?

  Mr Tiner: I did not see the programme but I am aware of the programme and read about it. We said in that paper—and it is a core piece of our regulation as business models change and more outsourcing is embraced by the industry—that the responsibility for the outsourcing operation is the senior management of the company that we regulate. We have absolutely no intention of changing that. I think we have to look to the boardrooms of the big UK institutions who are outsourcing, whether it is to India or to other places, to satisfy themselves that data is protected, that fraud is reduced, that there are back-up systems if the systems collapse. They need to be aware of criminal gangs who try to infiltrate some of these organisations and so on.

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